Policy uncertainty, slower growth may present investors with opportunity
As global politicians, businessmen and academics gather in Davos for this year’s World Economic Forum (WEF), our expectation is that the current uncertainty with respect to global growth will be a hotly debated topic.
Globalisation is the key theme for this year’s event and so as investors we find it appropriate to examine the possible effects of globalisation in a decelerating growth environment in the context of equity markets.
It is widely accepted that globalisation offers many advantages and is especially beneficial to emerging markets as an increasingly integrated world encourages trade, better technology and innovation and improves access to global capital markets.
However, in the current environment of heightened political uncertainty and slowing global growth, financial globalisation may place pressure on risky assets in emerging markets such as South Africa, as global investors exit these markets and gravitate towards ‘safer’ investments. This ultimately leads to depressed company valuations in local markets which may not be reflective of the longer-term prospects of a country, industry or company.
A slower global economic growth trajectory is likely to place pressure on emerging market growth. However, as investors flee for safety, markets can overshoot on the downside thereby creating opportunity for those investors who are able to look through the noise and focus on the longer-term opportunities of an individual company. In our view, the best way to take advantage of attractive valuations that may materialise in this environment - and at the same time mitigate the risk faced by uncertain growth trajectories - is to invest in ‘quality’ companies.
What constitutes quality in a company may be subjective, but we believe that there are some key metrics which encompass both the quantitative and qualitative attributes of a company. On the quantitative side, there are three principal areas that should receive attention - financial strength, profitability and cyclicality of earnings. For example, to weather a decelerating growth environment, a company should have a strong balance sheet, a degree of defensiveness which reduces earnings volatility and the ability to sustain profitability. Vodacom and Clicks have recently demonstrated these attributes, especially in the tough economic conditions we are currently experiencing in South Africa.
Qualitative factors are more difficult to quantify and rely on a level of investor judgement and intuition. Here one would evaluate industry specific factors such as regulatory risk, structural growth and barriers to entry. Further, one would look at more company specific factors such as strength of management, earnings visibility and transparency in reporting. AVI Limited is top of mind here. The company has very strong management, operating in an industry with relatively high barriers to entry and has proven to have good earnings visibility.
Corporate governance should also be an important consideration when determining whether a company should be considered quality- just as the Steinhoff debacle of 2017 reminded us. Board independence and executive compensation are key aspects to examine here. In addition, social and environmental factors are becoming increasingly important to consider when investing in a company.
The absence of many powerful world leaders at Davos this year is a stark reminder of the problems many countries face and will continue to face in 2019. Growth concerns in China, Brexit and a United States government shutdown are just a few factors keeping these leaders at home and equity markets will no doubt be jittery this year.
However, at the same time, astute investors will be focusing on quality companies with attractive long-term growth opportunities where poor sentiment has unduly punished the share price. When making these investment decisions, we suggest that investors consider the quality factors mentioned above.
In the words of Warren Buffet, famous for his preference for quality investing, ‘Whether we’re talking about stocks or socks, I like buying quality merchandise when it’s marked down’.